CIRD81350 - R&D tax relief: Conditions to be satisfied: Production and distribution of goods and services
Overview
Research and development projects seeking to make advances in science and technology in order to develop new or improved products or services, or new or improved production processes are the mainstay of the schemes.
Many activities within a company’s R&D project which contribute to seeking such advances will be capable of falling within the definition of R&D for tax purposes. These include: scientific or technological planning work involved in the company’s project; scientific or technological design, testing and analysis undertaken to resolve scientific or technological uncertainty associated with seeking the advance in science or technology that is the subject of the company’s project; and work to create or adapt software, materials or equipment needed to resolve this scientific or technological uncertainty (provided that the software, material or equipment is created or adapted solely for use in the company’s R&D project).
Certain other activities, which may form part of a company’s R&D project, are specifically excluded from the scope of R&D for tax purposes. These include the range of commercial and financial steps necessary for innovation and for the successful development and marketing of a new or appreciably improved process, material, device, product or service; and the production and distribution of goods and services (production activity).
However, the R&D project can continue after the company has started undertaking production activity. The R&D project only comes to an end when the company’s work to seek the advance by resolving scientific or technological uncertainty ceases. An example might be if the company produces a new product for supply to a customer, and the company needs to undertake scientific testing during and after its production as part of the work to seek the advance in science or technology. While the production activity to manufacture the product is excluded from the scope of R&D for tax purposes, the company’s scientific testing work wouldn’t be excluded.
So, certain additional activities undertaken alongside or around production activity may be within the scope of R&D for tax purposes (e.g. additional staff to monitor the process, extra testing equipment), and eligible additional expenditure on such activities can be included in claims made under the R&D schemes. It is only the core production expenditure - i.e. expenditure on production labour, raw material & components, and energy etc. - that has to be excluded from claims.
Also, in certain circumstances, undertaking a manufacturing process could fall within the scope of R&D for tax purposes, if is being undertaken solely in order to resolve scientific or technological uncertainty to seek the advance in science or technology, and not also to produce goods for supply to a customer. An example might be operating a new process incorporating a new technology, which the company has been developing in its R&D project, where any output from the process will only used for testing purposes or as scrap. (But, if the process is also being undertaken as production activity, with a view to producing goods for sale, then the activity is excluded from the scope of R&D for tax purposes.)
Introduction
This guidance explains how the exclusion of the production and distribution of goods and services operates, and uses the term ‘production activity’ to refer to the activity excluded from the scope of R&D for tax purposes on this basis.
The activities that constitute R&D for tax purposes are those activities which fall to be accounted for as R&D under generally accepted accounting practice (whether or not disclosed as such in the accounts) and also fall within the special definitions set out in the BIS (formerly DTI) Guidelines for activities to be treated as either ‘directly contributing’ to seeking the advance in science or technology, or as ‘qualifying indirect activity’.
The BIS (formerly DTI) guidelines provide that for R&D to take place there must be a project seeking to achieve an advance in science or technology. Certain activities within that that project are distinguished by the Guidelines. Those are activities undertaken to seek the advance in science or technology through the resolution of scientific or technological uncertainty, which fall within the special meaning of the term ‘directly contribute’ defined in the guidelines, or within the specific definition of ‘qualifying indirect activities’.
Paragraph 28(c) of the Guidelines excludes ‘the production and distribution of goods and services’ from the scope of the definition of the term ‘directly contribute’.
The effect of paragraph 28 is that any contribution that production activity makes to seeking or achieving an advance in science or technology is treated as an indirect contribution. And as it is not a qualifying indirect activity, as defined in paragraphs 31 and 32 of the guidelines, the activity is excluded from the scope of R&D for tax purposes by Paragraph 5 of the Guidelines.
What is production activity?
Production activity is the manufacture, or attempted manufacture, of goods, or the delivery or attempted delivery of services for customers. It does not matter whether the goods or services are successfully made and sold or not. So if a production risk (e.g. operator error) or a commercial risk (e.g. lack of a buyer) arises preventing goods or services from being sold, the activity still constitutes ‘production activity’.
On the other hand, undertaking a manufacturing process solely in order to resolve scientific or technological uncertainty to seek the advance in science or technology, is not ‘production activity’ (because the activity is not attempting to manufacture goods). An example might be operating a new process incorporating a new technology that the company has been developing in its R&D project, where any output from the process will only used by the company for testing purposes or be recycled, given away, or scrapped.
Under the large company scheme, a company may be eligible for relief where it is undertaking an R&D project paid for under contract by another large company (or certain other persons), subject to satisfying all the relevant conditions for relief. The fact that the knowledge relating to the advance in science being sought is passed to the party paying for the project does not in itself raise an issue, given that the legislation explicitly provides for relief to be available to a company undertaking an R&D project paid for under contract.
However, any manufacturing of goods or delivery of services that would be excluded if the company were retaining that knowledge itself should be excluded.
Example 1
A large company undertakes R&D projects under contract. A typical project involves development of new technology using radiation to detect narcotic or explosive substances at greater range and through more ‘opaque’ materials than current equipment is capable of. The possibility of successfully developing the technology is highly uncertain. However, customers are prepared to pay for development projects despite the uncertainty of success because of the great need for new technology in this area, the public benefit that results and the huge risks to society associated with the inability to perform this sort of detection.
The result is drawings, supporting physics and engineering write ups explaining the process, prototypes and demonstration equipment. All intellectual property and equipment passes to the customer. The cost of constructing the equipment passing to the customer is excluded from relief, as it is production of goods for the customer.
Example 2
A global pharmaceutical business has a foreign parent and intellectual property holder with a UK subsidiary which performs pre clinical and clinical R&D projects to develop new pharmaceutical products. The inter-company agreement describes the UK subsidiary as entitled to reimbursement on a cost plus basis for the costs of the projects, with all rights in the knowledge arising from the project belonging to the parent. So, all the information on chemistry, synthesis, toxicology, clinical trial data and associated statistical analysis, clinical trial protocols and so forth belongs to the foreign parent meeting the costs of the R&D project - and this is all that the parent receives.
The UK subsidiary can obtain relief under the large company scheme on the same basis as if it were undertaking the R&D project on its own account. (Though, if as part of the project that subsidiary was also manufacturing the drug concerned for supply either to external customers or to internal customers within the group, then the costs of manufacturing the drug would be excluded from relief.)
Example 3
A company is seeking to make an advance in technology which will enable a flooring production process to be automated. There is significant technological uncertainty as to whether and how, this can be achieved.
The company runs the new process as part of its work to resolve the technological uncertainty, on the basis that any output will, after testing, be scrapped or given away. This is not production of goods.
The same would be true if some of the output had to be sent to a potential customer for testing, so long as it was provided to the potential customer for free, or remained the company’s property.
If the output was being sold to a customer this would be production of goods, including if the flooring was sold as ‘seconds’.
Example 4
A customer approaches a company to buy a single new piece of equipment. The company cannot make what the customer wants without making an advance in technology, and decides it is worth undertaking an R&D project because if it succeeds there would be a wider market for such equipment.
In order to resolve the technological uncertainty involved in making an advance, the company makes a number of prototypes, which are not supplied to the customer. If the R&D project succeeds then the company supplies a single piece of equipment for the customer - production of this piece of equipment is production of goods.
How is expenditure on production activity treated?
Production activity is excluded from the scope of R&D for tax purposes, and so expenditure on such activity cannot be included in claims for R&D tax credits. Though, certain additional activities undertaken alongside or around production activity may be within the scope of R&D for tax purposes (e.g. additional staff to monitor the process, extra testing equipment), and eligible additional expenditure on such activities can be included in claims made under the R&D schemes. It is only the core production expenditure - i.e. expenditure on production labour, raw material & components, and energy etc. - that is specifically excluded.
Paragraphs 3 and 4 of the 2004 Guidelines provide that R&D takes place when a project seeks an advance in science or technology and that the activities within the project which constitute R&D for tax purposes are those that are treated as ‘directly contributing’ to achieving this advance through the resolution of scientific or technological uncertainty (within the special meaning of the term ‘directly contribute’ defined for the purposes of the Guidelines) as well as certain specific ‘qualifying indirect activities’. (Any other activities within the project fall outside the scope of R&D for tax purposes.)
Paragraph 27 of the Guidelines provides that certain activities, including activity to create software, equipment and materials solely for use in R&D, can be treated as ‘directly contributing’ to seeking or achieving the advance, while paragraph 28 provides that certain listed activities, including ‘the production and distribution of goods and services’, can not be treated as ‘directly contributing’.
For the purposes of the Guidelines, the effect of paragraph 28 is that any contribution that production activity makes to seeking or achieving an advance in science or technology is treated as an indirect contribution. And as it is not a qualifying indirect activity, as defined in paragraphs 31 and 32 of the guidelines, the activity is excluded from the scope of R&D for tax purposes by Paragraph 5 of the Guidelines.
Does it change the nature of a production activity if it does not actually result in goods or services being sold?
No. Where a process attempts to produce goods or services for customers - i.e. it is not undertaken solely for R&D - then it is a production activity excluded from the scope of R&D for tax purposes, whether or not the company actually succeeds in producing and selling any goods or services to customers.
In particular, the materialisation of a production or commercial risk - either in relation to producing the goods or services, or in relation to selling them (e.g. goods or services fail to meet customer specifications, cancelled orders etc.) - does not affect the exclusion of production activity from the scope of R&D for tax purposes.
For example, R&D is undertaken to develop a new process technology. The development and design work may qualify, as may the operation of the process solely for testing purposes. But the activity of producing goods does not qualify, whether or not the company succeeds in making and selling the goods.
What if an activity to seek an advance in science or technology is also a production activity?
If an activity has a dual role, for example seeking an advance in science or technology by resolving uncertainty and attempting to produce goods or services for customers then the status of the activity as production activity means that it is excluded from the scope of R&D for tax purposes, irrespective of the main purpose of undertaking the activity.
For the purposes of the Guidelines, production activity cannot be treated as making a ‘direct contribution’ to seeking or achieving an advance in science or technology. And as it is not a qualifying indirect activity, as defined in paragraphs 31 and 32 of the guidelines, the activity is excluded from the scope of R&D for tax purposes by Paragraph 5 of the Guidelines.
For example, suppose a company carries out an R&D project and part of the activity needed to resolve scientific or technology in order to seek an advance in science or technology involves development and construction of a prototype. The design and development work, testing and modelling can all qualify (subject to the general requirement that the activity contributes to seeking the advance in science or technology). Whether the construction activity (and relevant expenditure - e.g. manufacturing labour, raw material & component, and energy) qualifies depends on whether the prototype is constructed solely for use in the company’s R&D project, or also as goods.
What if operating a production process is necessary to test the process?
Only where the activity is undertaken solely for R&D could the activity be R&D for tax purposes. So if it is also undertaken as a production activity (e.g. to produce goods or deliver services), then it is excluded from the scope of R&D for tax purposes.
Paragraph 27(c) of the 2004 Guidelines provides for ‘scientific or technological design, testing and analysis undertaken to resolve the scientific or technological uncertainty’ to be treated as directly contributing to R&D. So a range of activities taking place before and alongside the production activity could be R&D for tax purposes (e.g. fundamental modelling and design work on a plant, setting up instruments, taking measurements, analysing data, making further modifications to the design) - subject to satisfying all other conditions because these activities are not production activity. But the activity of manufacturing goods, for example, is production activity (and so is excluded from the scope of R&D for tax purposes), whether or not it is necessary to enable the testing to be undertaken.
For the purposes of the Guidelines, any contribution that production activity makes to seeking or achieving an advance in science or technology is treated as an indirect contribution because the production and distribution of goods and services is excluded from making a direct contribution. And as it is not a qualifying indirect activity, as defined in paragraphs 31 and 32 of the guidelines, the activity is excluded from the scope of R&D for tax purposes by Paragraph 5 of the Guidelines.
What is the treatment of activity to construct prototypes?
Under the 2004 Guidelines construction of a prototype falls within paragraph 27(a), which provides that activity to create equipment can be treated as ‘directly contributing’ to seeking an advance in science or technology, but only if it is created solely for use in R&D. The guidelines therefore allow for the construction of a prototype to be capable, in principle, of being R&D for tax purposes, providing that its construction is needed to resolve the scientific or technological uncertainty in order to seek an advance in science or technology.
However, a prototype which is also created with a view to supplying it as goods to a customer is specifically excluded from being treated as ‘directly contributing’, both because it does not meet the ‘created or adapted solely for use in R&D’ condition in paragraph 27(a), and because production activity is excluded by paragraph 28(c).
Expenditure on other related work, such as computer modelling, testing of scale models or scientific or technological testing of material properties, undertaken alongside the production activity, could, potentially, be eligible for relief - subject to its satisfying the various conditions for being R&D expenditure.
For the purposes of the Guidelines, any contribution that production activity makes to seeking or achieving an advance in science or technology is treated as an indirect contribution. And as it is not a qualifying indirect activity, as defined in paragraphs 31 and 32 of the guidelines, the activity is excluded from the scope of R&D for tax purposes by Paragraph 5 of the Guidelines.
Do paragraphs 39 and 40 of the 2004 Guidelines affect the treatment of prototypes and pilot plants?
No. Paragraphs 39 & 40 in the Commentary section of the Guidelines are consistent with definitional paragraphs 27(a) and 28(c) of the guidelines - which provide that the activities of constructing a prototype or pilot plant, or operating a pilot plant can be R&D if a prototype is, or a pilot plant and its output are, solely for use in R&D. Where the activities are also production activities, they fall outside the scope of paragraph 27(a) and are specifically excluded from the scope of R&D by paragraph 28(c).
